Investing in mutual funds can play a key role in building capital to support one’s future, but what exactly are mutual funds and how can they be used? Why should mutual funds be considered as part of a long term financial planning strategy?
Mutual funds have become extremely popular over the last two decades with the industry currently managing over $12 trillion of assets. But what is a mutual fund and what role can it play in an investment strategy?
One of the key benefits of investing in mutual funds is simplicity. Basically, a mutual fund brings together a group of investors, who invest their money in stocks, bonds and other securities. Each investor owns shares, which represent a portion of the holdings of the fund. The vehicle generates income in two key ways:
Income from stock dividends and interest on bonds
Income from the fund selling securities which have increased in price
The income that the fund generates is reflected in the price of the fund. When investors sell their shares they can realise any profits made. In addition some mutual funds give investors the option to receive income payments in cash, whereas some will automatically reinvest income in the fund.
What are the advantages of investing via mutual funds?
As mentioned, mutual funds are a straightforward investment vehicle, which provide investors with a ‘one-stop-shop’ for investing in a chosen stock market. They are professionally managed and represent a relatively inexpensive way for small investors to get a full time manager to make and monitor their investments.
By owning shares in these funds instead of owning individual stocks or bonds, risk is also diversified. The idea behind this ‘investment spread’ is to invest in a large number of assets so that a loss in any particular investment is minimised by gains in others. Large mutual funds may own hundreds of different stocks in many different industries. It wouldn’t be possible for an investor to build this kind of a portfolio with a small amount of money.
In addition, because a fund buys and sells large amounts of securities at a time, its transaction costs are lower than those an individual would pay for dealing in smaller amounts of the same securities.
Another key benefit is that just like an individual stock, a fund allows the investor to request that their shares be converted into cash at any time.
Finally, buying a fund is very straightforward. Look for companies that offer mutual funds from more than one manager, and where minimum investments are small. For many people the ability to automatically invest a small amount every month is also important.
How should mutual fund investments be managed?
As with any investment there are potential risks with any stock market investment as investments can go up as well as down. However, there are a few basic guidelines, which should be adhered to when investing in mutual funds.
Investments should be divided into short term (less than five years) and long term (more than five years) again to balance risk with reward.
Funds should be chosen that reflect your financial goals and investment targets. The longer you plan to invest for, the more sensible it may be to take more risk.
If goals are short term, funds should be monitored more regularly.
For the average investor, large cap funds are the best investment options as often are less volatile than small to mid-cap funds.
If the markets drop, don’t panic – share price ebbs and flow are normal and investors should have a medium\ long term investment outlook.
Finally, ensure investments are diversified across different asset classes in order to manage and spread risk.
Conclusion
As part of a balanced savings portfolio, mutual funds can play a key role in growing capital whether for general savings, children’s education or retirement planning. Mutual funds provide diversification and professional management in a way that nearly everyone can access. It is absolutely essential that individuals begin financial planning as soon as feasible as this provide the timelines necessary to build a financial ‘nest egg’, which will support both themselves and their families in later years.
Jonathan Kemp is Chief Actuary of TAKAUD. OPinion expressed are his own and do not necessarily reflect that of Gulf News.
